Friday, February 20, 2009

Thanks for the memories, but they don't tell the true story

By Aline van Duyn
Published: February 20 2009 02:00 Last updated: February 20 2009 02:00
You Can't Put Your Arms Around A Memory is a moving song by the late Johnny Thunders, who hit the New York rock scene in the 1960s and a few years later was one of the founders of the band New York Dolls.
The song keeps echoing in my mind because it seems to embody the problem that is at the centre of this financial and economic crisis.
On the one hand, no one would deny that the financial system is in crisis and that things need to change.
Yet, many of the assumptions of the past still affect expectations and behaviour.
This is not surprising.
The entire financial system hinges on the ability to, at least to a large extent, quantify risks. And much of this depends on observing past patterns.
Confidence in these predictions has, of course, taken a huge hit. Risks were significantly underestimated and, with hindsight, many people should have known better, especially as there were plenty of smart voices out there warning of the problems.
But, even with the knowledge that much was awry, markets remain a collection of people and the behaviour, thoughts and expectations of these people remain extremely relevant.
This week there was one very clear example of this.
The high priest of laisser-faire capitalism, Alan Greenspan, told the Financial Times that he endorsed the nationalisation of some US banks, an idea that would have seemed impossible just a few months ago.
By taking over the banks, as regulators did with insolvent US savings and loans institutions a couple of decades ago, toxic assets could be moved to a bad bank without having to worry about how they are priced.
The most interesting comments were those the former chairman of the Federal Reserve made about bondholders in banks.
"You would have to be very careful about imposing any loss on senior creditors of any bank taken under government control because it could impact the senior debt of all other banks," said Mr Greenspan.
"This is a credit crisis and it is essential to preserve an anchor for the financing of the system. That anchor is the senior debt."
If banks are indeed nationalised, why should bondholders automatically assume that they will not have to bear any pain?
Indeed, if banks are facing shortfalls which wipe out the cushions provided by equity and other forms of capital that carry more risk than that taken on by senior bondholders, can a case really be made that taxpayers should take that hit, and not bondholders?
Indeed, the government's desire to spread the pain as widely as possible in troubled industries is already being made clear in the crisis around carmakers.
So far, bondholders in General Motors and Chrysler are resisting taking a bigger loss than others. Despite the enormity of what is at stake, they are not volunteering to take additional losses for the sake of some greater good.
Indeed, one of the benefits of bankruptcy proceedings is that courts decide who takes the hits, not politicians, and this may end up being the way the car industry is restructured.
A hard-headed reassessment of risk is needed. And that means that the risks that were miscalculated have to be acknowledged.
The problem is that this has to be done not just for one big company, or one big sector of the economy - such as cars - but for the entire financial system.
In Against the Gods , Peter Bernstein's seminal book about risk, he says: "The revolutionary idea that defines the boundary between modern times and the past is the mastery of risk: the notion that the future is more than a whim of the gods. . .
"Until human beings discovered a way across that boundary, the future was a mirror of the past or the murky domain of oracles and soothsayers."
The memories that investors cling to have proved to be based on completely wrong assumptions, on fallacies.
As long as efforts to cling to those persist, the results will be damaging.
Johnny Thunders was right about that.
aline.vanduyn@ft.com